Another IBD Scolded for Due Diligence No-No

Independent broker/dealer David Lerner & Associates was slapped with a FINRA complaint last week, claiming the firm failed to do adequate due diligence into "valuations and distribution irregularities" of Apple REIT Ten, a non-traded real estate investment trust. The complaint alleges:

The complaint against DLA alleges that since at least 2004, the closed Apple REITs have unreasonably valued their shares at a constant price of $11 notwithstanding market fluctuations, performance declines and increased leverage, while maintaining outsized distributions of 7 to 8 percent by leveraging the REITs through borrowings and returning capital to investors. As sole distributor, DLA did not question the Apple REITs' unchanging valuations despite the economic downturn for commercial real estate.

What else is new? Broker/dealers are getting nailed left and right for lack of due diligence on certain investment products, especially alternatives. And we're do quick so place the blame on the firm that sold the products. DLA responded by vehemently denying FINRA's claims:

In our opinion FINRA’s complaint is baseless and so rife with falsehoods, distortions, and misleading statements that if it were judged by the securities industry’s standard of SEC Rule 10b-5, FINRA itself would be in violation. It is apparent to us that DLA and other small firms have become the scapegoats for FINRA’s utter failure to address Madoff’s fraudulent scheme.

In connection with DLA’s decision to serve as the underwriter of Apple REIT Ten, Inc., the firm conducted thorough due diligence of Apple REIT Ten’s offering documents and audited financial statements. DLA takes comfort in noting that the US Securities and Exchange Commission thoroughly reviewed Apple REIT Ten’s registration statement for compliance with registration and disclosure requirements and declared the offering effective. DLA also takes comfort in noting that FINRA conducted a thorough review of the Apple REIT Ten offering and specifically approved DLA’s role as underwriter and its compensation for such services.

But we're also quick to place blame on the product itself (not naming any names ahem, New York Times). I sat down today with execs from the National Association of Real Estate Investment Trusts, who stressed the differences between publicly-traded REITs, which are more liquid but are traded like a stock on an exchange, and non-traded REITs, which are more illiquid and do not trade on an exchange. Michael Grupe, executive vice president of research and investor outreach at NAREIT, said that his understanding of the complaint was that the risk/reward tradeoff wasn't properly communicated to investors. Part of being an investor is knowing the risks and communicating with your b/d and advisor, he added.

Brad Case, senior vice president of research and industry information at the organization, said it's more an issue with non-listed assets in general and getting the information they need on what those investments are really worth. That's just the nature of these non-listed-type-of-investments, and investors should be aware of the risks involved.

That said, these investments do serve a purpose. Broker/dealers just might have to take this as a sign to tread lightly, making sure clients know what they're getting into so it doesn't turn into another landmine that they have to deal with.

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